Stock-Bond Correlation: Theory & Empirical Results

Abstract

Stock-bond correlation is an important component of portfolio allocation. It is widely used by institutional investors to determine strategic asset allocation, and is carefully monitored by multi-asset fund managers to implement tactical asset allocation. Over the past 20 years, the correlation between stock and bond returns in the US has been negative, while it was largely positive prior to the dot-com crisis. Investors currently believe that a negative stock-bond correlation is more beneficial than a positive stock-bond correlation because it reduces the risk of a balanced portfolio and limits drawdowns during periods of equity market distress.

In this study, we provide an overview of stock-bond correlation modeling. In the first part, we present several theoretical models related to the comovement of stock and bond returns. We distinguish between performance and hedging assets and show that negative correlation implies a negative bond risk premium due to the covariance risk premium component. In contrast, the payoff approach can explain that bonds can be both performance and hedging assets. In addition, a good understanding of the stock-bond correlation requires an assessment of the relationship between the aggregate stock-bond correlation at the portfolio level and the individual stock-bond correlation at the asset level. Macroeconomic models are also useful in interpreting the sign of the stock-bond correlation. They can be divided into three categories: inflation-centric, real-centric, and inflation-growth based.

The second part presents the empirical results. We find that the joint dynamics of stock and bond returns differ across countries. The negative stock-bond correlation is mainly associated with the North American market and the European market before the European debt crisis. When sovereign credit risk is a concern, we generally observe a positive stock-bond correlation. However, even in the US, we cannot speak of a unique stock-bond correlation, as the level depends strongly on the composition of the equity portfolio. We also confirm the influence of the inflation factor, but the results for the growth factor are not robust. Finally, we show that the stock-bond correlation is mainly explained by the extreme market regimes, since the stock-bond correlation can be assumed to be zero in normal market regimes.

Keywords: Stock-bond correlation, risk premium, payoff approach, growth, inflation

JEL Classification: G11, C01, E3